Pension Funds and Sustainable Investment: Challenges and Opportunities

A new book from the Pension Research Council is for anyone interested in understanding the historical context, current practices and future prospects of ESG investing in the pension industry.

Efforts to integrate environmental, social and governance criteria into institutional investing, including pension funds, have undergone significant shifts over the years. Our new Pension Research Council volume offers an invaluable resource for anyone interested in understanding the historical context, current practices and future prospects of ESG investing in the pension industry. Now available from Oxford University Press via Open Access, the book provides a variety of viewpoints from several countries on whether, how and when ESG criteria should, and should not, drive pension fund investments.

Investors have diverse motivations for incorporating ESG criteria into their investment strategies. Some individuals, including those with religious or ethical beliefs, may prioritize holding companies that align with their values, providing a sense of alignment between financial objectives and personal convictions. ESG considerations may also offer the prospect of risk mitigation. By factoring in environmental, social and governance factors, investors seek to assess a company’s sustainability and long-term viability. Considering these factors may help investors identify potential risks and make more informed investment decisions.

Nevertheless, divestment rarely changes company behavior, so screening and divestment may not bring about the changes that investors seek. Some argue that active ownership and engagement can be more effective in influencing corporate behavior. By actively engaging with companies, investors can advocate for positive change, encourage transparency and push for better ESG practices.

Responding to Market Failures


In economic terms, externalities refer to costs or benefits from economic activity that affect individuals or society at large, but which are not reflected in the market prices of goods or services. If firms impose costs on third parties without proper pricing, it creates a gap where the price paid by consumers does not fully account for the harm caused by the externality. For instance, if an oil refinery pollutes the environment and harms people or the surrounding area, the costs of the pollution are borne by neither the producer nor the consumers of the refined oil. This is an example of a negative externality, where the social costs exceed the private costs.

Economics offers two general ways to address such problems. One is through government intervention to alter the costs and benefits associated with production, using regulation, taxes or subsidies that internalize the external costs or benefits and align them with market prices. Another is to change the fiduciary rules or responsibilities under which producers operate by incorporating environmental, social and governance factors into the firm’s investment decisionmaking. In the context of pension investments, there may be a tension between a fund’s desire to invest in profitable fossil fuel firms and the potential social losses imposed by such investments. This tension often drives the debate over the pros and cons of ESG investment.

Indeed, the debate surrounding ESG investment often centers on the interpretation of fiduciary duty and the perceived trade-offs between financial returns and societal impact. For instance, some critics contend that pursuing ESG goals might compromise financial performance and, therefore, go against the primary responsibility of fiduciaries. Others argue that the influence of ESG considerations on company behavior is limited and that divestment or engagement efforts do not bring about significant changes. Instead, they suggest the primary focus should be on generating strong returns to fulfill pension obligations. By contrast, ESG supporters propose that considering environmental, social and governance factors can contribute to long-term sustainability and financial resilience, and neglecting ESG risks can lead to financial losses and increased volatility in investment portfolios. Additionally, adherents argue that ESG factors can serve as indicators of potential risks that may affect companies’ financial performance. Advocates also suggest that taking into account beneficiaries’ values and broader societal impact is in line with pension managers’ fiduciary duty, since beneficiaries, as ultimate stakeholders, may favor investments that align with their values.

Clearly the debate is not binary, and there is a wide spectrum of opinions between these two positions. Many investment professionals and institutions recognize the potential benefits of integrating ESG considerations while seeking to balance financial returns and societal impact. While there is evidence suggesting a positive correlation between ESG performance and financial performance, there is also evidence indicating the opposite, so striking the right balance between financial returns and societal impact ultimately requires careful consideration of the specific circumstances and objectives of each investor.

An Historical Perspective

The volume also outlines the origins of ESG to the pre-modern era from the post-Industrial Revolution late 19th century to about 1970, during which time governance concerns were prominent. Not only did policymakers seek to limit monopolies and ownership of companies by banks and families, but they also pushed antitrust regulation, uniform accounting/reporting/disclosure rules and two-tiered board structures in which supervisory boards retained control while managers executed company strategies. Beginning around 1970, the modern ESG era began, in which the U.S. was ahead of others in tackling environmental challenges. At the time, the debate was over whether investors should design separate portfolios for E, S and G or to develop a single common portfolio for all three. Now there is evidence forconvergence,” meaning that thinking about environmental, social and governance concerns is increasingly seen as a joint endeavor. The ESG evolutionary process has also been driven by a wave of government mandates and governance attributes bringing an early focus on environmental and social issues and catalyzing actions by the United Nations.

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The long horizons governing pension fund and other institutional investors render them particularly vulnerable to many long-lived ESG risks, including reputational risk; human capital-related risks; litigation risk; corruption risk; and climate risk, including the risk of stranded assets, among others. Additionally, pension funds confront the trade-off between “values versus value,” because they have a fiduciary responsibility to protect the financial interests of their members, who depend on them to secure their retirement nest eggs. Therefore, all investment decisions must clear the test of financial prudence, including having a clear rationale for using environmental and social factors in guiding those decisions.

Practical Challenges


One major problem with deciding how to invest in the ESG space is how to measure the inputs and impacts of ESG. In fact, one prominent research team cautions that ESG raters’ scores differ widely, making it difficult to generate reliable portfolios, given current data. Another consideration is whether pension plan participants should have a voice in their pension plan’s investment choices. Noting the difference between the U.S. approach—leaning toward hard law and sometimes-conflicting DOL regulations—and the European approach—more driven by social norms—the volume suggests that the answer depends on a fund’s legal and societal contexts, benchmarking pressure and fund-specific factors such as the fund’s size and the board’s composition.  

In the future, ESG-related thinking and investment will continue to evolve, focusing on several new components. Among these are transition risk, or the degree to which companies have prepared for regulatory and market changes; physical risk, or assets’ exposure to climate change; disclosure risk, or how firms disclose risks to resources necessary to their function but not reflected on their balance sheets; liability risk, due to potential lawsuits; and risks of labor strife, reputation or supply chain disruptions. The continued evolution of ESG investing in the pension setting must be driven both by a recognition of the diverse risks and opportunities these factors present and by institutional investors taking ESG factors into account in a thoughtful and informed manner.

Ultimately the question of whether and how pension systems should take ESG criteria into account is certain to transform into a broader set of considerations, namely, whether and how companies’ environmental, social and governance practices contribute to their long-term performance. Accordingly, executives and investors will need to integrate these considerations into their assessment of a company’s culture and innovation potential, employee retention and consumer satisfaction. Moreover, researchers must do more to enhance our understanding of what business activities are most successful at creating long-term value. Shareholders and, indeed, all of us will benefit with this broader conception of the risks and rewards associated with the impact of corporations on the economy.  

Olivia S. Mitchell is the executive director, Pension Research Council Director, Boettner Center for Pensions and Retirement Research at The Wharton School, University of Pennsylvania.

This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.

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